This article is from the May/June 2010 issue of Dollars & Sense: Real World Economics, available at

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This article is from the May/June 2010 issue of Dollars & Sense magazine.

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Dear Dr. Dollar:

With the crisis in Greece and other countries, commentators have said that governments are “under pressure from the bond market” or that bond markets will “punish” governments. What does this mean?
—Nikolaos Papanikolaou, Queens, N.Y.

It means that money is power.

The people and institutions that buy government bonds have the money. They are “the bond market.” By telling governments the conditions under which they will make loans (i.e., buy the governments’ bonds), they are able to greatly influence governments’ policies.

But let’s go back to some basics. When a government spends more than it takes in as taxes, it has to borrow the difference. It borrows by selling bonds, which are promises to pay. So the payments for the bonds are loans.

A government might sell a bond that is a promise to pay $103 a year from the date of sale. If bond buyers are confident that this promise will be kept and if the return they can get on other forms of investments is 3%, they will be willing to pay $100 for the bond. That is, they will be willing to loan the government $100 to be paid back in one year with 3% interest. This investment will then be providing the same return as their other investments.

But what if they are not confident that the promise will be kept? What if the investors (“the bond market”) think that the government of Greece, for example, may not be able to make the payments as promised and will default on the bonds? Under these circumstances the investors will not pay $100 for the bonds that return $103 next year. They may be willing to pay only $97.

If the government then does meet its promise, the bond will provide a 6.2% rate of return. But if the “bond market’s” fear of default turns out to be correct, then these bonds will have a much lower rate of return—or, in the extreme case, they will be a total loss. The “bond market” is demanding a higher rate of return to compensate for the risk. [The 3% - 6.2% difference was roughly the difference between the return on German and Greek bonds in March, when this column was written. By May, the return on Greek bonds was up to 16%. —Eds.]

However, if the Greek government—or whatever government is seeking the loans—can sell these bonds for only $97, it will have to sell more bonds in order to raise the funds it needs. In a year, the payments (that 6.2%) will place a new, severe burden on the government’s budget.

So the investors say, in effect, “If you fix your policies in ways that we think make default less likely, we will buy the bonds at a higher price—not $100, but maybe at $98 or $99.” It is not the ultimate purchasers of the bonds who convey this message; it is the underwriters, the large investment banks—Goldman Sachs for example. As underwriters they handle the sale of the bonds for the Greek government (and take hefty fees for this service).

Even if the investment banks were giving good, objective advice, this would be bad enough. However, the nature of their advice—“the pressure from the bond market”—is conditioned by who they are and whom they represent.

Foremost, they push for actions that will reduce the government’s budget deficit, even when sensible economic policy would call for a stimulus that would be provided by maintaining or expanding the deficit. Also, investment bankers will not tell governments to raise taxes on the rich or on foreign corporations in order to reduce the deficit. Instead, they tend to advocate cutting social programs and reducing the wages of public-sector workers.

It does not require great insight to see the class bias in these sorts of actions.

Yet the whole problem does not lie with the “pressure from the bond market.” The Greek government and other governments have followed policies that make them vulnerable to this sort of pressure. Unwilling or unable to tax the rich, governments borrowed to pay for their operations in good times. Having run budget deficits in good times, these authorities are in a poor position to add more debt when it is most needed—in the current recession in particular. So now, when governments really need to borrow to run deficits, they—and, more important, their people—are at the mercy of the “bond markets.”

Popular protests can push back, saving some social programs and forcing governments to place a greater burden on the wealthy. A real solution, however, requires long-term action to shift power, which would change government practices and reduce vulnerability to “the pressure from the bond market.”

Arthur MacEwan is a professor emeritus at the University of Massachusetts-Boston and a Dollars & Sense Associate.

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